There may come a time in your financial journey when you consider retaining a financial advisor. You will have many options.
Here are some issues for you to consider before making that critical decision.
Do You Need a Financial Advisor?
In recent years, the investing landscape has undergone a seismic shift. Selecting a suitable portfolio is no longer a daunting task, requiring a dizzying array of mutual funds. Some investors would be well-served by a low-cost Target Retirement fund or LifeStrategy fund in an appropriate asset allocation from Vanguard or other mutual fund families.
You can read more about the pros and cons of target date funds here.
This ease of investing has contributed to a rise in “DIY” (do it yourself) investors over the past few years.
Since you have the ability to invest on your own, when should you consider working with a financial advisor?
Just because you can invest without professional assistance doesn’t mean you should. An advisor can add value by identifying tax issues, providing more nuanced investing options and keeping you on course when the market takes a dive.
They can also assist with your asset allocation (the division of your portfolio between stocks, bonds and cash), ensuring that your portfolio is properly diversified, rebalancing your portfolio to ensure you are not taking too much or too little risk, and engaging in tax loss harvesting when appropriate.
Over time, these activities can add significant value.
Some experts recommend retaining an advisor when you are able to save 20% of your annual income or when your financial situation is overwhelming you or when there’s a major change, like an inheritance.
Apart from helping with your investments, there are many other ways a financial advisor can benefit you.
Some advisors provide comprehensive financial planning, which clarifies your goals and charts a course for meeting them. The plan may identify hidden risks or opportunities, like refinancing your mortgage, gaps in insurance coverage, inadequate estate planning and tax planning issues.
For some investors, these benefits will outweigh the fees charged by the advisor.
Benefits of An “Evidence-Based” Advisor
Once you’ve made the decision to seek professional assistance, it’s time to decide how to select an advisor who will serve you the best.
Initially, you should eliminate from consideration those who are not Registered Investment Advisors (RIAs). An RIA is legally and ethically required to always act in your best interest, avoid conflicts of interest, and disclose any conflicts.
RIAs are highly regulated and required to make extensive disclosures which you can access on the website of the Securities and Exchange Commission.
RIAs have different investment philosophies. These differences can have a major impact on your investment returns, so it’s important that you are aware of them.
“Evidence based” advisors rely on peer-reviewed evidence in making investment recommendations.
Evidence based advisors don’t pretend they can eliminate uncertainty in investing. They don’t claim to have the ability to forecast the future.
They don’t try to pick stock “winners” or time the market by investing when they believe the market is primed for an upturn or “fleeing to safety” before a project downturn.
Few investors understand the data indicating the dismal performance of actively managed mutual funds. Here’s a glaring example.
In 2021 the S&P/S ratio 500 index gained an impressive 28.7%. Yet 79.6% of active mutual fund managers underperformed these returns, according to a report prepared by S&P Dow Jones Indices (known as the SPIVA U.S. Scorecard).
Think about that for a moment. The S&P 500 Index is a market-capitalization-weighted index of 500 leading publicly traded companies in the U.S. The mission of these active mutual fund managers was to select from this group of companies those that would outperform others in the index.
These fund managers have massive resources and technology to assist them in their goal. Still, almost 80% of them failed.
A Better Way
Evidence-based investors believe there’s a better way. They limit their investment recommendations to index funds, exchange-traded funds (ETFs) and passively managed funds.
Index funds and ETFs simply track the performance of a particular index (like the S&P 500 index). The fund manager buys all or a representative sampling of the stocks in the index, so the returns will be the same as the returns of the index, less the management fee of the fund.
“Passively managed” mutual funds are defined by Morningstar as a fund where the securities aren’t chosen by the portfolio manager, but rather automatically selected to match an index or part of a market.
The benefits of investing in index funds, instead of actively managed funds, include lowering your risk by holding a diversified portfolio, lower taxes due to less turnover, and lower management fees because they don’t incur the cost to pay expensive portfolio managers who are engaged in an often futile effort to “beat the market.” Of course, investing in index funds doesn’t eliminate market risk.
You can read more about the differences between index funds and actively managed funds here.
The Performance of Evidence-Based Investing
The higher costs of actively managed funds makes it very difficult for them to outperform lower cost index funds, especially over the long term.
Over the ten-year period ended December 2021, only 26% of all active funds beat the average of comparable index funds. The higher the fees of the actively managed funds, the more likely they were to underperform.
The major benefit of using an evidence based advisor is their adherence to investing based on rigorous academic data, rather than emotions. They focus on factors they can control, like the amount of risk appropriate for you, global diversification and low fees.
They invest for the long-term and pay little attention to short-term market fluctuations.
Over time, according to Forbes, investing in index funds and passively managed funds are likely to generate superior returns compared to actively managed funds.
For all these reasons, choosing an advisor who is “evidence-based” may be a prudent decision that benefits you over the long-term.